April 15, 2009 (Housing Market Monitor)

House Prices and the Troubled Assets of Banks

By Dean Baker

April 15, 2009

There is no reason to expect that house prices will again have a sharp divergence from the long-term trend.

The Obama administration’s plan for disposing of troubled assets seems to have been constructed without any consideration of the state of the housing market. The administration seems to believe that the troubled assets held by the banks would command a much higher price, if only the market were operating normally.

While the subsidy implicit in the risk-free leverage provided under the plan will raise the price that investors would be willing to pay for the banks’ troubled assets, there is little reason to believe that the fair market price would be substantially higher than the 30 cents on the dollar that these assets are commanding in FDIC auctions.

The problem is simply that house prices have plunged since banks made these loans. For example, prices in the bottom third of homes in San Diego have fallen 49.5 percent from their peak in 2006. In Los Angeles, the drop has been 49.8 percent, while prices of bottom tier homes in San Francisco have fallen by 57 percent. In Miami, the price decline has been 49.8 percent and in Phoenix the drop has been 61.5 percent.

It is totally believable that the mortgages were issued near the peak of the bubble on the homes in these markets, typically with little or no down payment, and by now would have lost the bulk of their value. In all of these markets, prices are still falling rapidly (the declines refer to the Case-Shiller 20 City Index data through January). The legal and administrative costs associated with a foreclosure average approximately 25 percent of the sale price, implying that the 30 cents on the dollar price that many of these loans are now commanding in FDIC auctions reasonably reflects the recovery value from these assets.

It is also worth noting that house prices have fallen sharply since the banks’ troubled assets problem first became a major issue. In Miami, prices for the bottom tier of houses have fallen 22.6 percent between July 2008 and January 2009. In Las Vegas, the drop was 26.0 percent and in Phoenix, 36.6 percent. This means that if the assets were worth 60 cents on the dollar back in July, they would be worth far less than 50 cents on the dollar and close to 40 cents in the case of Phoenix.

In other words, the market price of mortgages in these markets would have been falling rapidly, following the prices of the houses that they financed. A value that might have seemed reasonable last summer would not be reasonable today.

In this respect, there is little reason to believe that the market is under-valuing the banks troubled assets to any substantial extent. It is true that these assets would regain value if house prices were to move back toward their bubble level, but there is no more reason to expect a re-inflation of the bubble than there was to expect the Nasdaq would return to 5,000 after its collapse in March 2000. House prices in the former bubble markets are in the process of falling back to their long-term trend level. There is no reason to expect that house prices will again have a sharp divergence from the long-term trend.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.